# Forex - Parity Relationship - Part 3

@*CS Siddharth Bumb. * , 12 February 2014

Hello Friends,

First of all thank you so much for your support and lovely response.

In earlier parts of Forex we saw some basics of Forex, in this part we will move to Parity relationships, I will try my best to simplify, hope you will understand.

Please click below for earlier parts :

FOREX PART 1

FOREX PART 2

* Factors affecting Forward Rate:-

Guys many time many questions are arise in your mind that why forex rates change, how they changes and what factors cause to chnge these rates.. Now read carefully you will understand.

There are various factors which are affecting the forward rates of exchange between currencies of two countries. Important of them are as follows:

A) Balance of Payment situation

B) Parity Relationships

Now we will understand both situations one by one :

A) Balance of payment situation :

Many of you may be aware of this. It is a systematic record of transaction of residence with non-residence over a period of time.

Here is the explanation :

If balance of payment situation is favourable, it means that we are exporting more and importing less due to which foreign currency tends to be cheaper as compared to domestic currency.

If balance of payment situation is adverse, then we can say that we are importing more and exporting less due to which foreign currency tends to be costlier as compared to home currency.

B) Parity Relationships :

Following are the 4 parity relationships which will be affecting forward rate of exchange:

a> Interest Rate Parity

b> Inflation Rate Parity (Purchasing power Parity)

c> Expectation Parity (Expectation Theory)

d> International Fisher's effect

Now, we will have to look above parities one by one :

a> Interest Rate Parity:

As per this theory forward rates of exchange between currencies of countries will be affected by their Interest Rate differentials.

Now you might be thinking that how is it possible ??

---> Dear, first we will have formula of it then I will try to solve your querry by Logic with an example.

Formula:

1 + R (d)   =   F(d) / F     (this formula is for Direct quote)

1 + R (f)        S (d) / F

or

1 + R (d)   =   S (f) / D      (this formula is for Indirect quote)

1 + R (f)         F (f) / D

(by using any of the formula we can solve the problem)

where,

F(d) / F = Forward Domestic per Foreign

S(d) / F = Spot domestic per foreign

S (f) / D = Spot foreign per Domestic

F (f) / D = Forward foreign per Domestic

R (d) = Domestic rate of interest

R (f) = Rate of Interest of foreign country

I know there is mess up in your mind, nowgo through example as given below then read again

Example :

Assume that, US borrowing rate is 6%, Indian deposit rate is 10%, and spot rate is 1\$=Rs 60.

Now, what I will do, Suppose I will borrow \$ 100 from US @ 6% p.a. and will deposit in Indian bank account account @ 10% p.a. basis.

It means, I will deposit Rs 6000 (\$ 100 * Rs 60) and will earn Interest Rs 600 after 1 year. Now I have Rs 6600 in my hand in Indian currency and I have to pay \$ 100 + \$6 (Interest @ 6% on \$100) = \$ 106 in US.

Now in next step, amount which I received in India alongwith interest i.e. Rs 6600 I will convert in \$ for payment of dues. It will be \$ 110 (Rs 6600/60).

Now look overall scenario, I have \$ 110 in my hand after conversion but I have to pay \$ 106 in US, now it means I am in profit of \$ 4 ( \$ 110 - \$ 106)...??

ANSWER comes NO, NOT AT ALL. (Dear agar aisa hota tha to koi bhi country poor nahi hoti thi), then I know next question in your mind is whats the correct answer is ?

---> Now in this case Rate of Dollar would increase... but how ?

I have Rs 6600 (6000+600) in my hand and I have to pay \$ 106(100+6).

New rate will be Rs 62.2642/\$ (Rs 6600/106).

Rs 62.2642 will be new rate and outstanding dues i.e. \$ 106 will be paid at this rate.

Hence,we can say that interest rate parity affects the forward rates of currency. (See the difference, earlier rate was 60 and now it is 62.2642.)

Now, above rate can come by using formula :

1 + R (d)   =   F(d) / F     (this formula is for Direct quote)

1 + R (f)        S (d) / F

1 + 0.10   =   F(d) / F

1 + 0.06           60

Rs 62.2642 / \$

Assumption :

1. Spot rate is same throughout the year

2. There is no restrictions of FEMA

Hence we can say that, The country where interest rates are lower, currency of that country will be at premium and vice versa.

I hope you guys are getting.

b> Inflation Rate Parity (Purchasing Power Parity) :

As per this theory forward rates of exchange between the currencies of two countries will adjust according to their inflation rate differentials.

(Logic which we have seen earlier, same applies here)

Formula:

1 + I (d)   =   F(d) / F     (this formula is for Direct quote)

1 + I (f)        S (d) / F

or

1 + I (d)   =   S (f) / D      (this formula is for Indirect quote)

1 + I (f)         F (f) / D

(by using any of the formula we can solve the problem)

where,

F(d) / F = Forward Domestic per Foreign

S(d) / F = Spot domestic per foreign

S (f) / D = Spot foreign per Domestic

F (f) / D = Forward foreign per Domestic

I (d) = Domestic rate of inflation

I (f) = Rate of Inflation of foreign country.

c> Expectation theory :

As per this theory, forward rates of exchange will move according to expectations of forward market participants. If forward contracts are selling cheaper than expectations of forward market participants then they tend to buy currency in forward market due to which forward rates of currency starts rising and reaches to expectation level of forward market participants. If forward market is selling costlier than expectations of formard market participants then they need to sell the currency in forward market due to which forward rates of currency declines and riches to expectation level of forward market participants.

Friends, entire market of currency or share market is move mostly by expectations of participants.

As market moves by expectation of participants formula becomes like this:

F (d) / F = E [ S(d) / F ]

E [ S(d) / F ] = Expected spot rate at future.

d> International Fisher's Effect:

It is the combination of both Interest rate parity and Inflation rate parity. As per this theory, forward rate can be affected by both interest as well as inflation too. But the concept remains the same just like interest rate parity and inflation rate parity.

Formula:

1 + R(d)    =   1 + I (d)

1 + R(f)          1 + I (f)

I hope guys you got these parity relationships. If you face any problem please contact me at siddharthbumb@gmail.com

Regards,

Siddharth Bumb

siddharthbumb@gmail.com

@*CS Siddharth Bumb. *
(B.Com, CA Final, CS )
Category Students   Report

1 Likes   62 Shares   18738 Views

Accounting

CA Rahul Malkan

CCI Articles